8/24/2009 @ 12:00AM

Keeping Down With The Joneses

The idea of middle-class prosperity is America’s great contribution to the world. During the cold war, it was an effective weapon against the Soviets. In the 1959 Kitchen Debate between Vice President Richard Nixon and Soviet Premier Nikita Khrushchev, for example, Nixon steered clear of the moral virtues of democratic liberalism. Rather, he celebrated the way in which a free economy had improved the quality of life for America’s working majority. While Khrushchev was convinced that there was more to life than dishwashers and hi-fi sets, quite a few of his compatriots disagreed. To them, the dazzling array of labor-saving machines that had emancipated millions of Americans from household drudgery was proof enough of capitalism’s virtues.

Since then, societies across the world have enthusiastically embraced markets in an effort to build their own flourishing middle classes, and many have succeeded.

Yet in the United States, a decade of sluggish growth in jobs and wages has left much of the middle class in rough shape. From 1999 to 2009, there was virtually no growth in private-sector employment. The public sector has been responsible for most of this decade’s modest job gains. Over the same period, GDP has grown at an average rate of 1.9% a year, a shade below the 2% rate achieved during the long and miserable decade of oil shocks and stagflation that ran from 1973 to 1983.

Last year, economists Christian Broda and David Weinstein published Prices, Poverty, and Inequality, a useful primer on middle class consumption. Their basic argument was that improvement in the price and quality of mass-produced consumer goods, driven in part by the rise of low-cost Chinese manufacturing, had sharply improved living standards for middle-class Americans, while the rising cost of household services had diluted economic gains to the more affluent. So while countless scholars and politicians were decrying middle-class squeeze, Broda and Weinstein suggested, reasonably enough, that we consider the bright side.

But while middle-class Americans certainly enjoy more and better consumer goods, they are also carrying extraordinarily high levels of consumer debt. The collapse in the housing market is one obvious culprit. The number of homes in negative equity has gone from 2.5 million in 2005 to over 15 million and climbing. Apart from driving the explosion in foreclosures, which has only begun, it keeps families shackled to their homes, thus preventing them from moving in search of job opportunities.

Citing 2007 data from the Federal Reserve, Tom Petruno of the Los Angeles Times recently noted that while the top 10% of earners have debt-to-disposable-income ratio of 116%, and the bottom 40% of earners have a ratio of 133, those in between–that is, middle-class households–have a ratio of 205%. This 50% slice of the population represents 46% of consumption, and it is precisely this group that will have to dramatically pare back its consumption to pay down its debt. This is a recipe for weak consumer demand for a decade or more, which means another decade of sluggish growth.

Until recently it seemed possible that the top 10% of earners, who represent 42% of consumption, could fuel the economy on their own. In 2005, Ajay Kapur, then working for
Citigroup
, maintained that the United States had become a “Plutonomy,” an economy dominated by the wealthy. His team estimated that in 2005, 60% of spending could be attributed to the top 20% of households, a number that is broadly in tune with the Federal Reserve’s 2007 data.

What happens next is a mystery. Though the super-rich have been dealt a blow, they’ve already begun a comeback, as evidenced by robust corporate earnings. Perhaps we’ll rely, as we have for the past decade, on this small slice of the population to drive the economy during a long jobless recovery. It’s not clear, however, that this strategy is sustainable. Just as sensible investors try to diversify their portfolios, relying on a small number of households concentrated in a small number of sectors exposes the economy to tremendous risk. Building a more balanced economy might actually reduce the severity of downturns.

More immediately, it’s easy to imagine an overburdened middle class lashing out at the more affluent. During the health care debate, moderate Democrats in the House have proposed steep tax increases on high earners that could push marginal tax rates close to 50%. Efforts to fund new entitlements through steeply progressive taxes will in all likelihood lead to a sharp spike in tax avoidance and a reduction in work effort. It’s vitally important that we avoid going down this road. A broad-based consumption tax would, as Bruce Bartlett has explained, be vastly preferable. That, of course, would do nothing to alleviate middle-class woes.

A good first step would be to ease the burden on middle-class households. Harvard economists Kenneth Rogoff and Gregory Mankiw have both called for the Federal Reserve to commit itself to generating a modest amount of inflation, a strategy that could dramatically ease the de-leveraging process while raising the risk of an uncontrollable inflationary spiral. My sense is that this is a risk worth taking.

Another wise move would be to abandon our current approach to mortgage modification, a complicated morass that includes a means test that might actually create work disincentives, and replace it with a “right-to-rent,” an idea championed by the liberal economist Dean Baker of the Center for Economic Policy Research and conservative economist Andrew Samwick of Dartmouth. The basic idea is that delinquent homeowners would surrender all equity and in exchange be given the right to rent their homes at market rates for some period of time. In theory, this measure could save neighborhoods across the country from collapsing real estate values, mass abandonment and even crime.

Suffice it to say, these aren’t exactly awe-inspiring measures. It’s still true that we need to find new sources of growth if we’re going to secure middle-class prosperity for future generations. For now, however, easing the painful process of de-leveraging would do a tremendous amount of good.

Reihan Salam is a fellow at the New America Foundation. The co-author of Grand New Party: How Republicans Can Win the Working Class and Save the American Dream, he writes a weekly column for Forbes.